Tracking error (or trailing return as defined by Morningstar) is the difference between the return on the fund and the return on the fund’s benchmark.  (see http://library.morningstar.com/Education/MLE_Glossary_T_Z.html#TrailingR...). Tracking error should be small, meaning that the fund return is very close to the benchmark return. Generally, the smaller the tracking error, the more consistent the performance of the fund compared to its benchmark. If the tracking error is negative, the fund has yielded lower returns than the benchmark. Most people do not complain too much if the tracking error is positive, or in other words, the fund has yielded higher returns than the benchmark.

A fund’s tracking error is usually listed in the prospectus section entitled “Tracking Error: Returns: Performance History” (see Table 25.6). You should look at three major parts of the section that deals with tracking error: “Tracking Error versus the Index,” “Tracking Error versus the Category,” and “Percent Rank in Category.”

Tracking Error versus the Index (+/- Index): This section shows the difference between the return on the fund and the return on the benchmark or index. If this tracking error is consistently small, it is likely that you will receive the returns of the benchmark on a consistent basis.

Tracking Error versus the Category (+/- Category): Sometimes funds with similar objectives will have different benchmarks. This section combines all funds with similar objectives. This information indicates how well the fund performs in comparison with other funds in the same asset class (or category). A positive tracking error indicates that a fund has had higher-than-average returns as compared with other funds in the category.

Percent Rank in Category: This section shows the percentile in which a fund falls in a given category. A rank of 15 indicates that the fund is in the top 15 percentile of all funds; therefore, the lower the number, the better the performance of the fund versus the performance of other funds in the category. Watch this percent rank for consistency. A fund that is in the top third of all funds year after year is a much better prospect than a fund that is the top performer one year and a mediocre performer for several years. Remember that winners rotate, and last year’s best-performing fund is unlikely to be this year’s best performing fund. Consistency is a critical factor.

Table 25.6
Morningstar Website: Tracking Error